Chapter 7 - Pricing Flashcards
Why is pricing important?
- it makes a pivotal contribution to profit maximisation
- the amount they are able to sell often determined by the price charged for the goods and services
- businesses make profits by selling goods at a price higher than their cost
What are the 3 main factors that influence price?
- Customers
- Competition
- Cost
What does a perfectly competitive market look like?
- Zero entry/ exit barriers
- perfect information
- companies aim to maximize profits
- homogeneous products
What does an imperfect competitive market look like?
- Monopoly
- Oligopoly
- Monopolistic competition
What is a zero entry/exit barriers market?
relatively easy to enter or exit as a business in a perfectly competitive market
What perfect information in relation to a competitive market?
prices and quality of products are assumed to be known to all consumers and producers
What is monopoly in a imperfect market?
- In which there is only one seller of a good.
- The seller dominates many buyers and can use its market power to set a profit-maximizing price
What is oligopoly in a imperfect market?
- a few companies dominate the market and are inter-dependent: firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition.
What is monopolistic competition?
- products are similar, but not identical.
- many producers (‘price setters’) and many consumers in a given market, but no business has total control over the market price.
What are the 2 broad approaches to pricing?
- Demand based
- Cost based
- marketing based
Economic theory states that the monopolist maximizes profit when what?
Marginal cost = marginal revenue
What is marginal revenue?
The additional revenue from selling one extra unit
What is the marginal cost?
the cost of making one more unit. Usually the variable cost
What is the calculation to establish the linear relationship between price (P) and quantity demanded (Q) in the algebraic approach? (1)
P=a - bQ
What is ‘a’ in the algebraic approach?
the intercept - here the maximum theoretical price at which demand will fall to zero.
What is ‘b’ in the algebraic approach?
- the gradient of the line - here the amount the price has to change to change the demand by one unit
- always negative
How do we find the marginal revenue in the marginal revenue? (2)
Double the gradient to find the marginal revenue: MR = a -2bQ
What is the third step in the algebraic approach?
Establish the marginal cost MC. simply the variable.
How do we maximise the profit in the algebraic approach? (4)
equate MC and MR and solve to find Q
How do we find the optimum price in the algebraic approach? (5)
substitute the value of Q into the price equation to find the optimum price
How do we find ‘b’ in the algebraic approach?
Change in price/change in quantity
What is the tabular approach?
involves different prices and volumes of sales being presented in a table
What is the equation for the total cost function?
y=a + bx
a= the fixed cost per period
b= variable cost per unit
x = the activity level (independent variable)
y = total cost = fixed cost + variable cost (dependent variable)
What is the calculation for finding the price?
Price = cost per unit + chosen margin or markup
What is ‘mark-up’?
the profit expressed as a percentage of cost (cost is 100%)
What is ‘margin’?
the profit expressed as a percentage of the sales price (sales is 100%_
What is the main adv of standard costs?
the prices can be set in advance and fixed for the period concerned.
What is the main dis adv of standard costs?
is that if significant variances occur, then the price may have been set too low and a loss ensues
What is the main adv of actual costs?
a profit is guaranteed, however less incentive for the supplier to control costs as inefficiencies can be passed on to customers.
What is the adv of marginal or full cost?
Simpler - no need for the absorption of fixed o/hs
Consistent with the use of contribution in decision-making
Useful in short-term decisions.
What is the dis adv of marginal cost?
Setting an appropriate margin or markup as this will need to ensure all fixed costs are covered
What are the advs of using relevant costs?
- can be used to arrive at a minimum tender price for a one-off tender or contract.
- only suitable for one-off decisions
How do you calculate price elasticity of demand PED?
Percentage change in demand / percentage change in price
If PED < 1 what does this represent?
an inelastic product. This means demand is relatively insensitive to price changes
If PED > 1 what does this represent?
An elastic product: demand is relatively sensitive to price changes. This could occur if the product has many substitutes, or is a luxury item
What is market skimming?
- involves charging high prices when a product is first launched, to maximise short-term profitability
What are the conditions suitable for market skimming?
- product is new and different
- has little direct competition
- short lifecycle and their is a need to recover development costs
- firm with liquidity problems
What is penetration pricing?
the charging of low prices when a new product is initially launched in order to gain rapid acceptance
What are the conditions suitable for Penetration pricing?
- if a firm wishes to increase market share
- if firm wishes to discourage new entrants from entering the market
- if demand is highly elastic so would respond well to low prices
What is a complentary product?
one that is normally used with another product. e.g., razors and razor blades
What is a product line?
a range of products that are related to one another
When does product line pricing occur?
when setting the price steps between various products in a product line, based on:
- cost difference between the products
- customer evaluations of different features
- competitors prices
What is volume discounting pricing?
offering customers a lower price per unit if they purchase a particular quantity of a product
What are some benefits of volume discount pricing?
- increased customer loyalty
- attracting new customers
- lower sales processing costs
What is pricing discrimination pricing?
where a company sells the same product or services at different prices in different markets
What are some conditions required for a price-discrimination strategy?
- seller must have some degree of monopoly power
- effective for services
- there must be a different price elasticities of demand in each market so that prices can be raised in one and lowered in the other
What are some issues with price discrimination?
- competitors join the market and undercut the firms prices
- customers in the higher price bracket look for alternatives
